The Fed is Waking Up and Is putting its foot on the brakes!

“Hindsight says we should have moved earlier. . . . But there really is no precedent for this.”  Fed Chair Powell, March 3, 2022

The Yield Curve inverting has been the most accurate predictor of the economy tipping into a recession for the last 50 years. Typically, it takes about 6 months from the time the Yield Curve inverts for a recession to kick in. So, what exactly does an "inversion of the yield curve" mean? An inversion of the yield curve is looking at and referring to the differences in interest rates being charged by banks over a 2 and 10 year lending horizon. Economists also look at the 3 and 10 year lending rates as well.

Typically banks will charge a lower interest for a short term loan than for a longer term loan. Banks are incentivized to lend out at higher interest rates over a longer term loan period. However, when the 10 year interest lending rate is less than the 2 year lending rate, banks have less incentive to lend. This is known as the "yield curve inversion" when the longer term 10 year lending rate is less than than the 2-year rate. It does not happen often but when it does, it has been a good predictor of an upcoming recession for over 50 years. 

The spread between 10-year and 2-year Treasuries has fallen from 0.89% in early January to just 0.18% on March 21. So while we are close, we are not there yet.

If you are walking into The French Laundry, a 3 star michelin restaurant in Napa, you may well expect to pay $50 plus for a sandwich extraordinaire. Not so, when you walk into your average sandwich place. I almost fell out of my chair when the person cutting my hair told me she was going to be charged $50 for a chicken sandwich at a local eatery in Walnut Creek, La Fontaine. She had paid $20 for a sandwich one day, $30 the next and then a few days later was presented with the $50 price tag. She declined the sandwich. 

While this may be an extraordinary tale of sandwich inflation and who knows what else, the reality is that the cost of eating out has gone up significantly, but this is sandwich madness. Yes, Russia and Ukraine are two of the largest exporters of wheat and there will be supply shortages that impact prices worldwide. The Russia-Ukraine situation has also sent gas prices soaring. Gas prices have risen to some of the highest in recent USA history. However, has America stopped growing its own wheat and raising it's own chickens? Of course not. So, why is a local sandwich shop in Walnut Creek charging $50 for a chicken sandwich? Is it the best chicken sandwich in Walnut Creek? Probably not.

The supply chain issues have given opportunity for corporate and business greed to inflate as well. While some price increases may be justified, of course, some price increases across a range of industries ranging from 50-500% are quite litterally "out of this world" and unjustified by any rational commercial standards.

Authoritarian leaders have many things in common: A need for self-glorification, self-preservation, vanity and power are four of many. They can never get enough of these. One person dictates the future of millions held captive by fear and repression and effects millions in the Ukraine by what ammounts to an open decleration of war. On the one hand, Putin's agenda appears to be founded in reclaiming a long gone era of Russian influence and power and countering his fear of NATO expansion to Russia's borders. While this is no doubt influencing his decisions and causing mayhem with his fragile ego, one can also infer that what is motivating Putin - under the guise of a strongman - is fear for his own political surivival and his legacy with the West encroaching on his doorstep, a Russia that has been broken up and is only a part of it's former empire.

This is Putin's war, not Russia's war. Putin's strategic plan, if he follows through into Ukraine which looks more probable at this juncture, will have severe financial repercussions for Russia. Not only will maintaining a war be costly for Russia, the economic sanctions will - once fully implemented in the event of a full scale invasion of Ukraine - be crippling. The Ukraine will not sit idle with its 200,000 person army plus reservists joining them and funding from the west.

Russia's allies are few and not surprisingly are authoritarian leaders with their own empire building or reclaiming agenda's. China while overtly supporting Putin treads a fine line. It will be wary of supporting Russia too much as it still needs America as a trading partner and will therefore not want to further alienate the USA.

The possibility of war looms as Russia's build up of troops and tanks grow on the Ukranian border. As if that were not enough, inflation stats coming in at 7.5% provides continued proof of how wrong the Federal Reserve has been. Markets hate uncertainty and "uncertainty" is the flavor of the current moment. Russian-Ukranian tensions have been on the rise for weeks now. That is not news. A diplomatic resolution vs a military invasion has been the more expected outcome and that is now in question. Has that been fully discounted by the markets. Some say no.

A military build up of such magnitude is cause for alarm and certainly a strategic move by Putin to force an outcome whether that is to enter into negotiations and reach a new military understanding between Europe, Russia and the USA or potentially, an invasion. An invasion is costly on many fronts for Russia, not least of which will be the heavy sanctions that will be imposed on them by USA and Europe. War is costly and it is questionable whether Russia can afford such a prolonged entanglement. As such, it seems a high risk option for Putin and therefore less likely of an outcome to us. However, if the strategic goals for the build up were originally to negotiate a new military understanding in the region and these completely fail from Putin's vantage point, who knows what his next move could be.

In the midst of this, inflation continues to rear its ugly head. Supply chain issues abound. The Fed has to act and based on the most recent data, the market worries it will have to act even more aggressively. As we have said before in previous blog posts, we believe the Fed will act and a rate increase of at least 25 basis points is all but assured in March. It is again unlikely in our estimation that the first rate hike will be more than that. Based on our research supply chain issues will start to be addressed in the second half of 2022. However, progress may not materialize until later than the market would like. In this sceanrio more pressure will be put on the Fed to keep raising interest rates which they will probably do.